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Mad Catz has reported that the opinion letter for its independent audit carries concerns over the company’s ability to pay its debts. An audit opinion letter, a document prepared by the independent auditor as a narrative accompaniment to the financial assessment, includes what is known as a “going concern” note.

This happens when a company is at risk of defaulting on its debt obligations. Mad Catz’s 2016 success hinges on the performance of Rock Band 4 (via co-publishing agreement with Harmonix), according to form 10-K filed with the SEC on June 25.

The Company depends upon the availability of capital under the Credit Facility to finance operations. Compliance with the Adjusted EBITDA covenants in fiscal 2016, which are tied closely to our internal forecasts and include significant contributions from anticipated sales of products related to the Rock Band 4 video game, depends on the Company’s ability to increase net sales and gross profit considerably.

Also, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future sales and expenses. If the Company is unable to comply with the revised Adjusted EBITDA covenants contained in the Credit Facility, Wells Fargo could declare the outstanding borrowings under the facility immediately due and payable.

If the Company needs to obtain additional funds as a result of the termination of the Credit Facility or the acceleration of amounts due thereunder, there can be no assurance that alternative financing can be obtained on substantially similar or acceptable terms, or at all. The Company’s failure to promptly obtain alternate financing could limit our ability to implement our business plan and have an immediate, severe and adverse impact on our business, results of operations, financial condition and liquidity. In the event that no alternative financing is available, the Company would be forced to drastically curtail operations, or dispose of assets, or cease operations altogether.

These uncertainties raise substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

In short, the statement above indicates that Mad Catz is at risk (as of the close of its last fiscal year on March 31, 2015) of failing to comply with terms of its debt funding from Wells Fargo. In the event that it falls out of compliance, the lender can immediately call due all outstanding loan amount and applicable interest. Whether that happens or not is at the lender’s discretion at that time.

Mad Catz has since secured funding that will replace its Wells Fargo credit. The company provided us with an additional statement on the matter.

“This language was added because our debt covenants are tied to our budget and, as we have stated, we are anticipating significant growth in sales and gross profit from Rock Band 4 this year. This is great news,” Mad Catz chief financial officer Karen McGinnis tells us. “However, for KPMG, there was not enough audit evidence for them to conclude that it is probable we will make those projections since we just started taking preorders. If we don’t meet the projections, we will violate a debt covenant, which means the bank has the right to call the loan. However, we have violated debt covenants several times in the past, and Wells Fargo has always provided us with a waiver of default. Unfortunately, KPMG cannot just assume Wells Fargo will provide a waiver, which is why they were required to include this language.”

Mad Catz’s new funding amounts to $30 million in two pieces. One element is a $20 million line of credit that will increase to $35 million from September 1 through December 31, 2015, in order to ship Rock Band 4. The other $10 million is secured funding to Mad Catz Europe (a wholly-owned subsidiary). That funding is termed at three years, but can be canceled by the lender with three months notice.

Mad Catz has been running a string of operating losses, with the last postiive operating income reported for fiscal year 2011. The losses have been diminishing, but still remain. Net income was positive for the most recently completed fiscal year for the first time since 2011.

Harmonix indicates that this presents no disruption to its plans to ship Rock Band 4 for release on October 6.

Our TakeA “going concern” note in an audit opinion letter is reason for investigation, no matter how you spin it. I'm surprised that the chief financial officer admitted that the company has entered non-compliant status "several times" in the past and based solely on lender discretion avoided the loan being called.

The reason the lender would opt to agree to a waiver is based on a belief that there is a better chance of recovering more money (preferably through the established interest agreement) by waiting to see if the company can restore compliance than calling the loan immediately.

Everything might work out for Mad Catz if Rock Band 4 meets projections. However, it is clear the company is basing much of its future and its debt position on one title. Mad Catz is counting on people buying new hardware (guitars, drums, microphones) rather than using their old equipment. It's my hope that we don't see a repeat of the THQ/uDraw situation due to a surplus inventory of new Rock Band peripherals.